You’ve heard about the 4% Rule  aka 4% Safe Withdrawal Rate  aka the Multiply by 25 Rule. But, is it safe? To answer this, we have to look at where this rule of thumb came from: Back in 1994... (If you haven't heard about the 4% Rule? Start here.) BRIEFLY In the early 90s an "obscure advisor" (his words not mine) named Bill Bengen published a paper. He did a study to figure out how much money someone could safely take out of a retirement account and not run out of money after 30 years. The question still persists, is the 4% Rule Safe? I say yes. He had strict assumptions so that the study applied to everyone, and anyone would be able to improve on. ASSUMPTIONS
THE PROCESS To find the SAFE MAX, the percent that anyone could use, Bengen had to test all the combinations of his specified asset allocation, withdrawal rate, and starting year. The withdrawal rates he tested ranged from 2% to 8%, to see how long they would last with each asset allocation. Each combination was tested for every starting year that data was available for, beginning in 1926. Note: Bengen has since updated his study with the last 20+ years of data. In Year One, the withdrawal was equal to whichever withdrawal rate was being tested. In Years 2+, the withdrawal was the dollar amount from the previous year adjusted for inflation. Not the original percent! THE RESULT Bengen found that historically, 4.15% was the largest starting withdrawal rate someone could take out and still have money after 30 years. He called this the Safe Max, and thus the 4% Rule was born. This has since been updated to 4.5%, but according to Bengen in 2017:
SO IS IT SAFE? Let's go over the facts. The 4% Rule was developed by using the worst times in US history. It is conservative. The study assumes you'll never have any income, social security, or emergency fund. Conservative (and probably wrong). It assumes you won't cut back if the market goes south. Conservative (and dumb). So it it safe? Yes. For the 4% Rule (should be the 4.5% Rule) to fail we would have to see the worst ever times in US history. And not do anything about it. Of course it's possible to see worse times than we've seen so far, and to mismanage money. But even after all that you'd still have a Ton of money to get back on your feet with. So it's not totally foolproof, but it is very, very safe. SOURCES
There are a lot of articles out there about the 4% Rule, here are a few that I like.
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The 4% Rule. What is it? If you’ve been around the block of Financial Independence or Early Retirement (FI/RE) you have probably seen this come up. On its surface, it’s a simple rule of thumb. It guides how much money you can take in retirement and helps you determine how much you need. Unsurprisingly, it goes deeper than that. This is the first video in a three part series where I discuss what the 4% Rule is and its effect on financial planning. Let’s get started. WHY I CARE ABOUT THE 4% RULE The 4% Rule was the first thing that got me hooked on the idea of getting to Financial Independence early. I learned that I could multiply my annual spending by 25 and have a savings goal for Financial Independence. Nice simple math! Other thoughts quickly followed:
After this series, there will still be plenty of unanswered questions: “What what are the criticisms?” “How and why has the 4% Rule changed?” “What else do I need to consider?” Good questions, but for now, I’m just going to stick with the “birth” of the 4% Rule, not the toddler years or beyond. 4% RULE: DEFINITION The 4% Rule is a rule of thumb that guides a retiree to the amount of savings that can be withdrawn each year of a 30 year retirement. It was designed so that a retiree would maintain their current standard of living, by accounting for inflation. For a person planning on a 30 year retirement, 4% is the Safe Withdrawal Rate for the first year.
HOW TO USE THE 4% RULE YEAR 1 OF RETIREMENT If you were to use the 4% Rule in retirement, you would withdraw 4% of your portfolio during your first year. This is the amount needed sustain your current standard of living. For example: Say you have $1,000,000 in savings
That’s it. That is when the 4% is used. The first year. RETIREMENT YEARS 229: HANDLING INFLATION The 4% Rule has a very simple (and simplistic) answer for dealing with inflation and the rest of the “29” years of retirement. After the first year, you withdraw the same amount as the previous year plus inflation. Back to our example. Let’s assume an average 3% inflation during year #2:
Now, let’s assume 3.5% inflation for year #3:
As inflation varies, so does the amount that can safely be withdrawn from savings. The 4% Rule says that you should, in almost all cases, have enough money to sustain your current standard of living all the way to that 30th year. RETIREMENT PLANNING The “4% Rule is also used to calculate your savings goal. To do that, multiply your annual spending by the inverse of 4%. Divide 1 by 4% to get the inverse.
Fun fact, this is why the “4% Rule” is also called the “Multiply by 25 Rule.” Using the same example as above, let’s say you want to be able to withdraw $40,000 during your first year of retirement. How much do you need in savings?
That, at its most basic level, is the 4% Rule. WHY 4%? Why 4%? Who came up with it? If you, like me, aren’t comfortable with just that simple number, continue on. A link to the second video in this series will be here after it has been posted.
